Exam 17: Hybrid and Derivative Securities

Nico Yong is considering the purchase of 100 shares of Cisco Systems stock at $22 per share. Because the economy is picking up, Nico believes the demand for Oracle's router systems will increase substantially causing the price of Cisco's shares to increase to $30 per share. As an alternative, Nico is considering the purchase of a call option for 100 shares of Cisco at with an exercise price of $25. This 180 day option will cost Nico $200. Assume no brokerage costs or dividends. (a) What will Nico's profit be on the stock transaction if he decides to buy the stock and its price does increase to $30 per share and he sells? (b) How much will Nico earn on the option transaction if he purchases the option and the underlying stock price rises to $30? (c) How much must the stock price rise for Nico to break even on the option transaction? (d) Based on parts (a) and (b) above, what should Nico do? Explain.

Dwyer Corporation is determining whether to lease or purchase new equipment. The firm is in the 38% tax bracket, and its after-tax cost of debt is currently 7%. The terms of the lease and the purchase are: Lease: Annual end-of-year lease payments of $31,500 are required over the 3-year life of the lease. All maintenance costs will be paid by the leasor; insurance and other costs will be borne by the lessee. The lessee will exercise it option to purchase the equipment for $6000 at the termination of the lease. Purchase: The equipment, costing $77,000, can be financed entirely with a 12% loan requiring annual end-of-year payments of $32,059 for 3 years. The firm will depreciated the equipment under MACRS using a 3-year recovery period (33% in year 1, 45% in year 2, 15% in year 3 and 7% in year 4). The firm will pay $2000 per year for a service contract that covers maintenance costs; insurance and other costs will be borne by the firm. The firm plans to keep the equipment and use it beyond its 3-year recovery period. Calculate the present value of the cash outflow for both the lease and purchasing and recommend one alternative.

A derivative security is neither debt nor equity but instead derives its value from an underlying asset.

A ________ is normally initiated by a firm that needs funds for operations. An asset previously owned by a lessee is sold to the lessor.

The majority of actively traded warrants are listed on the

Since the purchaser of a convertible security is given an opportunity to become a common stockholder and to share in the firm's future success, convertibles can normally be sold with higher interest rates than nonconvertibles.

Consider the following options data: (a) Determine the amount of profit or loss associated with each option, ignoring brokerage fees. (b) Differentiate a warrant from a right.

At the time of issuance, the issuer of a convertible security normally establishes a conversion price ________ the current market price of the firm's stock.

The lessee is the receiver of the services of the assets under a lease whereas a lessor is the owner of the assets that are being leased.

FASB Standard No. 13 requires explicit disclosure of ________ obligation on the firm's balance sheet. For this type of lease, the present value for all of its payments is shown as an asset and the total lease payment obligation is included as a liability on the firm's balance sheet.

Call options are purchased with the expectation that the market price of the underlying security will rise while put options are purchased with the expectation that the market price of the underlying security will fall.

A firm has an outstanding bond with a $1,000 par value that is convertible at $40 per share of common stock. If the current market value of common stock per share is $45, the conversion value of the bond is

An overhanging issue is a convertible security that cannot be forced into conversion by using the call feature.

From the firm's point-of-view, the issuance of convertible bonds has all of the following advantages EXCEPT

A ________ is an option included as part of a bond or preferred stock that permits the holder to convert the security into a specified number of shares of common stock.

If an investor buys a 100-share call option for $250 with an exercise price of $60 and the underlying price per share of the stock at expiration is $66, what is the amount of profit or loss, ignoring brokerage fees?

An operating lease is noncancelable and obligates the lessee to make payments for the use of an asset over a predefined period of time.

The consequences of missing a financial lease payment are ________ those of missing an interest or principal payment on debt.

The similarities of a right and a warrant include all of the following EXCEPT

A security that is neither debt nor equity but derives its value from an underlying asset that is often another security is called